How to read the Income Tax Act

Continuing the new post series where I answer readers’ questions they’ve Googled to find my site, as logged by, the next one is sent chills down my spine: “How to read the Income Tax Act?”

The last time I cracked open the Act, it was probably tax class in university. Once you’re done those classes, there’s really no need to delve into the swirling mass of dense legalese again. There are many more comprehensible sources for tax information, so don’t read the Income Tax Act. In its place, do these things:

  • Read the Canadian Revenue Agency’s website. They write about tax in plain English (most of the time) and it’s reliable information since it is from the source.
  • Read accounting firm websites. All the major firms have sections on their websites that offer regular tax facts and updates, detailing bits of tax law applicable to your situation, whatever it may be. Again, plain English (for the most part, although we do tend to introduce jargon from time to time).
  • Read tax textbooks. I still do this when I want a refresher. Textbooks are occasionally dense, but usually still much easier to read and understand than the Act.
  • Call in to tax related TV call-in shows. These seem to be on regularly, on CityTV especially and other fringe channels that predominantly have call-in shows. They feature knowledgeable experts sharing advice for free.
  • Use tax software. If you own one of the tax packages people use to do their own taxes, these can be used to answer your questions in a meaningful way: with your numbers, or with dummy data as examples.

Reading the Act is best left to the professionals who have specialized in tax. As you can see, there are many alternatives, most of which are available on the web, that the average person can use instead to find guidance on any particular issue.


Are you an employee or independent contractor?

In Canada, there are no hard and fast rules in the Tax Act that help an individual determine whether they are an employee or an independent contractor. There are three tests, which have evolved through court decisions, that are used to assess the relationship between an individual and his/her employer. They are:

  1. Economic reality or entrepreneur test
  2. Specific result test
  3. Organization or integration test

Why is this important? Well, if you’re a contractor, or self-employed, you can deduct any reasonable expense incurred to earn income. There is a distinction in the Tax Act between the type of income earned depending on whether you’re self-employed or not. If you’re self-employed, you earn business income as a sole proprietor. If you’re employed, you (of course) earn employment income and are restricted in the types of expenses you can deduct for tax purposes.

An employer is also required to withhold income tax, Canada Pension Plan contributions and Employment Insurance premiums from their employees’ pay. If you’re a contractor you’re likely required by the CRA to make tax installments since no one is withholding for you your contribution to the treasury on a regular basis. (The issue of installments will be covered in a future blog post.)

But back to the tests.

Economic reality or entrepreneur test

There are three aspects to this test: control, tool ownership, chance of profit/risk of loss. If someone is not only telling you what to do but how to do it, they have control over the work and a strong case is made that they are your employer. If you own the tools you need to do the job and they are not provided to you, this points to the likelihood that you are independent. Finally, if you are profiting from the work and bearing the risk of loss due to cost overruns, it is even more likely you are a contractor.

Specific result test

If there is a defined piece of work you’ve hired to do and you’ve been given the freedom to accomplish it however you see fit, the employer-employee relationship likely does not exist. As an employee you’re typically hired to perform tasks with no specific result and on an ongoing basis. If there is a defined beginning and end to the work required, that’s a pretty good indicator you’re self-employed.

Organization or integration test

This test concerns itself with the dependence of the individual on the organization. If benefits ordinarily conferred on employees are available to the individual, then from the outside (i.e. the CRA) it appears the individual is an employee. In certain cases the proportion of an individual’s total income which comes from a single organization has been taken into consideration as well, although personally I don’t think this is particularly convincing metric.

To sum up: There is no specific section of the Act that lays out all the rules to help a taxpayer determine if he/she can deduct expenses from their income. The law has evolved through court decisions and they have been based on the above three tests, which should all be taken into consideration along with the specific facts of the situation.

As with any general tax discussion, your personal situation is unique and could require the expertise of a Chartered Accountant. If you need a CA, please contact me and I will be happy to help you find one in your area!


Engagement letter update

Before accountants can get down to the business of providing service to clients, we have to issue what’s known in the biz as an “engagement letter.” Contrary to what I’d initially thought, this doesn’t tie me down to any one person for the rest of my life, for better or worse, in good times and bad.

What it does is provide in writing the services agreed to by both parties in case anything goes wrong over the duration of the letter. My firm requires new engagement letters every three years. It spells out the services to be provided and the liability assumed by each party. This basically involves reminding the client it is all theirs (liability for the statements).

Which is what brings me to the point of the post – most clients don’t like the wording of the engagement letter, and I don’t really blame them. They hire us to perform some work and the first communication we send them basically says “can’t be held responsible.” Reminds me of The Freshmen by The Verve Pipe.

Dennis, at AccMan, has come up with a much better engagement letter template in a recent post on his blog. I like it because it’s plain English and it doesn’t make the accountants sound like we’re washing our hands of the client before we’ve even started getting them dirty.

Should the engagement letter be updated and translated into a more understandable English? Is it even possible, given its nature as a legal document?